Category: Market Action

Accrued Interest has a good piece today, elaborating his thoughts on the GSEs (which he insists on spelling with an apostrophe).

Did Freddie Mac move their ABS portfolio into Level 3 because they didn’t like the bid indications they were using for valuation? The company says no.
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Buddy Piszel, CFO: We made a determination in the first quarter, that given how widely the pricing we were getting on the ABS portfolio, that it no longer made sense to leave that in Level 2…. We were still using the mean price that we were getting from the pricing services and the dealers. So we are not using a model price
…
So if you believe what he’s saying, that means that the actual valuation would be the same either way. By moving to Level 3, they are saying they no longer believe the valuations represent “observable inputs.”

It seems clear that The Financial Accounting Standards Board is feeling some heat about Level 3, the so-called “Mark to Make-Believe” level of financial assets. They have published an article rather desperately titled Some Facts about Fair Value:

Like the many other estimates used in financial reporting (some of which require complex calculations), Level 3 estimates can be difficult and require the use of significant judgments. However, many investors clearly have indicated that such estimates provide more relevant and useful information than alternatives that ignore current economic conditions and that can introduce management bias into the estimation process (for example, alternatives that involve “smoothing” techniques and predicting recoveries in value).

To increase investor awareness about Level 3 estimates, SFAS 157 requires expanded disclosures about the Level 3 estimates used for financial assets and liabilities that are reported at fair value on an ongoing basis. Those disclosures focus on the effect of the estimates on reported earnings and financial position. More recently, the staff of the Securities and Exchange Commission issued a letter that encourages public companies to provide additional disclosures about the Level 3 estimates used for financial assets (including asset-backed securities, loans, and derivatives) in their Management Discussion & Analysis. The letter does not, as some have asserted, interpret, amend, or otherwise change the application of SFAS 157.

The SEC letter referred to has been published in generic form by the SEC:

Depending on your circumstances, the following disclosure and discussion points may be relevant as you prepare your MD&A:
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• The amount and reason for any material increase or decrease in Level 3 assets and liabilities resulting from your transfer of assets and liabilities from, or into, Level 1 or Level 2.
• If you transferred a material amount of assets or liabilities into Level 3 during the period, a discussion of:
  • the significant inputs that you no longer consider to be observable; and
  • any material gain or loss you recognized on those assets or liabilities during the period, and, to the extent you exclude that amount from the realized/unrealized gains (losses) line item in the Level 3 reconciliation, the amount you excluded.

It was Bloomberg that first – I think – broke the story about $157-billion in Level 3 assets, and an example of the kind of comments it has attracted is:

Freddie told investors right to their faces, “We manipulated the numbers,” and investors applauded like a bunch of idiots, pushing Freddie Mac shares up more than 9%. I wish this was the end to the tragic comedy, but Freddie’s conference call was even more ridiculous.
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And Freddie Mac just moved its entire Asset-Backed Security [ABS] portfolio to Level 3.

As a result, its Level 3 assets ballooned from $39 billion to over $157 billion in the first quarter. Its reasoning? The pricing the market was giving these securities varied too much. In other words, when the market was responsible for figuring out how much these assets were worth, the price fluctuated dramatically, providing the potential for major losses. So Freddie moved these assets to Level 3, where the market no longer has any say in their value. It’s yet another nail hammered into the coffin of what was supposed to be a capitalist free market.

The author is a newsletter writer, not (so far as I can tell) a portfolio manager.

The “smoking gun” in the financials is note 3, page 13 of Financial Statements and Core Tables:

At March 31, 2008, our fair value results were impacted by several changes in our approach for estimating the fair value of certain financial instruments, primarily related to our valuation of our guarantee obligation as a result of our adoption of SFAS 157 on January 1, 2008. These changes resulted in a net increase in the fair value of total net assets of approximately $4.6 billion (after tax).

See update below for more Freddie

Anyway … one man’s pain is another man’s gain! I mentioned the UBS Close-Out Special at about 68 cents on the dollar yesterday … today, Naked Capitalism observes that Bank Hapoalim has done the same:

the second largest bank in Israel, sold its entire portfolio of MBS to Pimco for 75 cents on an already-written-dollar (or in this case, shekel). Note that the previous writedowns were at least $90 million on an portfolio valued before the sale at $3.42 billion.

And the war between the Credit Analysis Department and the Market Price Department continues:

Based on the model supplied by the company, the Bank applied an even more severe scenario in which housing prices in the USA (excluding California and Florida) fell by about 30% from their peak (by 22% when compared with the present price level) and in California and Florida by about 40% from their peak (by 28% when compared with the present price level). Given such an severe scenario and assuming that the rate of default by mortgage takers will be about 47%, the accumulated loss from the portfolio is liable to reach about 340 million US Dollars over the life span of the securities.

The loss on sale was $870-million. I said it about Blackrock … I’ll say it about PIMCO … they’re going to make out like bandits. These well-publicized moves into the asset class by “real money” accounts bode well for normalization of the credit markets – although I will admit that Hapaolim’s 3.5-billion portfolio is a small part of the 1,400-billion problem.

Those who take my encouraging words about normalization as being the ravings of a Pollyanna are reminded that “normal” does not mean “good”. Spreads are still elevated and credit is still relatively scarce … and corporate defaults are rising. By “normalizing”, I mean that the chances of apocalyptic financial meltdown are declining, that’s all.

But real money is big-time sub-prime:

Gross, 64, anticipated the collapse of the U.S. housing market and the Fed’s subsequent interest-rate cuts. He shunned riskier corporate debt in 2006, a call that caused his fund to lag behind peers. Gross’s $128 billion Total Return Fund slipped as much as 4 percent in the first half of 2006.

The decision to sidestep subprime-linked debt has helped the fund surge 12 percent in the past year to beat 95 percent of its rivals, according to data compiled by Bloomberg.

Earlier this year, Gross started piling back into mortgage bonds to take advantage of slumping prices. In April, he lifted his holdings in mortgage-related debt to the highest since 2000, and lowered his stakes in U.S. Treasuries after calling them “overvalued.”

As of April 30, Gross’s Total Return Fund held 65 percent in mortgage debt, according to data posted on the firm’s Web site. The fund also holds 6 percent of assets in emerging-market debt. This year, Gross’s Total Return Fund has returned 4.1 percent, beating 94 percent of peers, Bloomberg data show.

As expected after the court ruling on BCE / Teachers’, BCE stock got slaughtered today, while Credit Default Swaps came in to 315bp from 595bp. Now, that’s a move! It appears that frenetic trading (over 26-million shares) gave the new Quantum trading system a work-out … BCE was halted in the mid-afternoon … a glitch this morning caused many issues (including CPD) to be temporarily halted. Finally, the TSX announced:

TSX Group has determined the root cause of a service disruption that affected trading on 37 of the more than 2100 issues trading on Toronto Stock Exchange.

The interruption was caused by a trading message protocol issue with one invalid message, and was entirely unrelated to TSX Quantum performance or capacity.

Corrective measures have been implemented.

Shares of BCE Inc. were halted at 2:14 p.m. to address data integrity concerns.

TSX expects trading in shares of BCE Inc. to open as usual tomorrow morning.

Not a lot of detail there, but there never is. It strikes me that if the system was compromised by a single “trading message protocol issue with one invalid message”, then Quantum probably needs a better input editor to prevent these data issues from fouling up the internal engine … but there isn’t enough information to make that conclusion firm.

There’s a bit more colour on BCE / Teachers’ … Bloomberg reports that a failure would help unwind the LBO crisis:

The potential cancellation of BCE Inc.’s C$52 billion ($52.9 billion) leveraged buyout may help loan prices recover by removing the largest portion of high- yield, high-risk debt banks need to sell from last year’s deals.

“If BCE is canceled it reduces the amount of debt on bank balance sheets substantially,” Chris Taggert, an analyst at fixed income research firm CreditSights Inc. in New York said in a telephone interview. “It’s the largest piece of the pipeline out there and would be a boost to the market.”

Loan prices have climbed as banks this year found a way to reduce their pipeline of loans promised last year to private- equity firms to $81.6 billion from $156 billion, according to Standard & Poor’s. Loans backing the acquisition of Montreal- based BCE, Canada’s biggest telephone company, comprise $16.8 billion, or 20.6 percent of the backlog.

Prices are up to an average 91.86 cents on the dollar, from a record low of 86.3 cents in February, according to S&P. Private-equity firms including Blackstone Group LP and Apollo Management LP have bought loans from banks, and the risk of financial institutions failing has subsided.
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“This is good news for” Toronto-Dominion, Desjardins Securities analyst Michael Goldberg wrote in a note to investors today. “A new deal or no deal would mean that TD would not experience losses on the syndication of its financing.”

The bank has probably marked down its BCE financing commitment by about C$150 million, mostly in the past two quarters, Goldberg said. The bank has said it agreed to finance about 10 percent of the equity portion of the BCE purchase, or about C$3.3 billion.

The excitement of the day was BCE, but the enormous price moves occurred on small volume. Apart from this name, the market was off slightly – not a lot, but enough to notice – on average volume.

There were nineteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Update: The specific disclosure of the move to level 3 is in the Supplement:

At March 31, 2008, we measured and recorded on a recurring basis $156.8 billion, or approximately 23% of total assets, at fair value using significant unobservable inputs (Level 3), before the impact of counterparty and cash collateral netting across the levels of the fair value hierarchy. Our Level 3 assets consist of non-agency residential mortgage-related securities and our guarantee asset. We also measured and recorded on a recurring basis $113 million, or less than 1% of total liabilities, at fair value using significant unobservable inputs, before the impact of counterparty and cash collateral netting across the levels of the fair value hierarchy. Our Level 3 liabilities consist of derivative liabilities, net.

During the first quarter of 2008, our Level 3 assets increased because the market for non-agency mortgage-related securities became less liquid, resulting in lower transaction volumes, wider credit spreads and less transparent pricing for these assets. In addition, we have observed more variability in the quotations received from dealers and third-party pricing services. Consequently, we transferred $153.8 billion of Level 2 assets to Level 3 during the first quarter of 2008. These transfers were primarily within non-agency mortgage-related securities backed by subprime and Alt-A mortgage loans where inputs that are significant to their valuation became limited or unavailable. We concluded that the prices on these securities received from pricing services and dealers were reflective of significant unobservable inputs. We recorded $11.2 billion in additional losses primarily in AOCI on these transferred assets during the first quarter of 2008, which were included in our Level 3 reconciliation. See “NOTE 14: FAIR VALUE DISCLOSURES— Table 14.2 —Fair Value Measurements of Assets and Liabilities Using Significant Unobservable Inputs” to our consolidated financial statements for the Level 3 reconciliation. For discussion of types and characteristics of mortgage loans underlying our mortgage-related securities, see “CREDIT RISKS” and “CONSOLIDATED BALANCE SHEETS ANALYSIS—Table 15 —Characteristics of Mortgage Loans and Mortgage-Related Securities in our Retained Portfolio.”

Update, 2008-5-23: Split-Share Performance, 2008-5-23

The big news today is a Moody’s methodological scandal:

Moody’s Investors Service said it’s conducting “a thorough review” of whether a computer error was responsible for assigning Aaa ratings to debt securities that later fell in value.

Some senior staff at Moody’s were aware in early 2007 that constant proportion debt obligations, funds that used borrowed money to bet on credit-default swaps, should have been ranked four levels lower, the Financial Times said, citing internal Moody’s documents. Moody’s altered some assumptions to avoid having to assign lower grades after it corrected the error, the paper said.

Naked Capitalism is ecstatic. Publication of the official release from Moody’s was delayed, but it there … albeit scooped by FT Alphaville.

Heads will roll. And quite rightly.

An Accrued Interest post on Freddie Mac was referred to yesterday. For those interested-but-not-all-that-much in the issue, Jonathan Weill reviews the accounting issues.

On the sub-prime front there is (via FT Alphavill) that UBS is having a close-out special on some sub-prime

UBS sold positions with a nominal value of approximately USD $22 billion to the new fund for an aggregate sale price of approximately USD $15 billion. Based on UBS categorizations, the vast majority of the positions are Subprime and Alt-A in roughly equal parts and the remainder is Prime. The fund purchased the securities using approximately USD $3.75 billion in equity raised by BlackRock from investors and a multi-year collateralized term loan of approximately USD $11.25 billion provided by UBS.

UBS is notorious for having an assets-to-capital multiple that was way off the charts. But, holy smokey! Sixty-Eight cents on the dollar? Since UBS is the seller, we may assume that the great bulk of it, if not all, is AAA tranches … and even Greenlaw forecast a mere 18.9% average loss. I think the Blackrock guys – and their investors – are going to make out like bandits on this.

There were forty-two other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Sorry folks! Today was boring on the news front AND I was busy, so there’s no macro-level commentary. Accrued Interest wrote a good piece on How Safe are the GSEs?.

Strength in the Floating Rate sector continues to astound; they’re really coming back a lot from their extreme depths. I don’t think it has anything to do with the credit, because the BAM perpetuals are still bumping along without any huge gains. PerpetualDiscounts are doing well, but this is simply in line with long corporates, which have returned +1.44% in the month to 5/20.

There were twenty-two other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Not much today, folks!

Naked Capitalism republishes some of a piece by Gillian Tett of the Financial Times regarding the advisability of managers talking to each other; her recommendations echo those of the International Report on Risk Management Supervision and provide a little bit of psychological colour.

Iceland is in trouble! Their Central Bank has had to borrow EUR 1.5-billion to prop up the currency:

The krona has dropped as much as 26 percent against the euro this year on concern Iceland’s commercial banks have taken on too much foreign debt, prompting speculation the central bank may have to step in.

The offer of aid from neighbors “will help stabilize the financial markets, but not the basic imbalances of the Icelandic economy,” said Lars Christensen, senior emerging markets strategist at Danske Bank A/S in Copenhagen.
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The country’s three biggest banks have combined assets of 11.4 trillion kronur, or nine times the size of the economy. At the biggest lender, Kaupthing Bank Hf, foreign currency holdings make up 87 percent of assets.

Meanwhile, the lines between “private equity funds” and “vulture funds” seem to be getting a little blurred:

McGoldrick, 49, was co-head of the Goldman group that buys corporate debt that is near default, lends to financially struggling businesses and trades shares of companies emerging from bankruptcy. His new firm, Mount Kellett Capital Management LP, will do transactions around the globe, said the people, who asked not to be identified because the venture is private.

Private-equity firms raised $163.5 billion in the first three months of 2008, the second-biggest quarter since London- based Private Equity Intelligence Ltd. started tracking the data in 2003. The money is coming from pension funds, endowments and sovereign wealth funds even as a shortage of credit has stopped most deal-making.

“There’s an appetite for serious distressed investors and he has a track record of having done a good job on those deals, so there will be some receptivity,” said Steven Kaplan, a finance professor at the University of Chicago’s business school.

“Private Equity” has a much nicer ring to it, doesn’t it?

Bloomberg has a good piece on the collapse of the Auction Rate Securities Markets. Amusingly – in a sick sort of way – is that the front-page link is “Auction-Rate Market Loses $1.7 Billion for Taxpayers Misled by Governments”, while the actual story headline is “Auction-Rate Collapse Costs Taxpayers $1.65 Billion”. There’s nothing that I can see in the story that would justify a charge that taxpayers were misled by governments … but in these days of heroic investor advocacy, it’s very fashionable to claim that anything not to one’s liking is unethical.

The story suggests:

Many issuers are getting out of auction-rate debt and say they will never use it again. State and local governments have already replaced or announced plans to replace at least $66 billion of the securities, according to Bloomberg data. Many are switching to variable-rate demand bonds, whose 2.25 percent average in the past month is about half the 4.56 percent for auction-rate bonds. Others are stuck, unable to issue new debt. Some investment banks, including Citigroup, say the market will never come back.

“It’s a damaged product, and I can’t imagine issuers using it again,” said Wisconsin’s Hoadley. “A lot of people will have to die and institutional memory go away before people will come back to it.”
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Gallatin, the father of auction-rate securities, doesn’t hold out much hope. He expects auction-rate bonds will be replaced by other debt because too many investors and issuers lack confidence.

“The back of the market is broken,” he said. “I think the market’s problem started with credit, but now credit isn’t the problem.”

Who knows? The doomsayers may well be right, and I must be very cautious when questioning Citigroup’s opinion regarding what they can sell … but it seems to me that the market could be resurrected in the same manner as Canadian (Bank Sponsored) ABCP … slap a global liquidity guarantee on the stuff and away you go! In other words, Citigroup could underwrite such an issue, with a guarantee that it will put in a permanent bid for the entire issue at, say BAs + 500 (guaranteeing a fixed rate for 40 years might be a little dicey!).

Again, who knows? Let’s wait for things to calm down and revisit the issue in, say, five years. The basic issuers’ Holy Grail of financing long term assets at short term rates, and the basic investors’ Holy Grail of getting an extra 20bp on pretend-short-term paper will never go out of style!

The drive to get authority for the Fed to pay interest on reserve balances (discussed on May 7 and April 29) continues with Bernanke writing Pelosi:

Federal Reserve Chairman Ben S. Bernanke asked Congress to immediately give the central bank authority to pay interest on commercial-bank reserves, according to a letter from the Fed chief to House Speaker Nancy Pelosi.

“Congress recognized that payment of interest on reserves would contribute to the efficiency of the financial system,” Bernanke, 54, said in a letter sent to Pelosi, a California Democrat. The central bank isn’t authorized by Congress to begin making such payments until October 2011.

“We recommend that the date be changed to make the legislation effective immediately,” Bernanke wrote in a letter dated May 13.

Performance was again nicely positive today, but volume was awful.

There were seven other index-included $25-pv-equivalent issues trading over 10,000 shares today.

I’m becoming more and more convinced that the Credit Crunch has evolved from its fundamental role as Reducer of Excesses to a new position as Political Football.

My thoughts on this are influenced by many things. For instance, compare the sub-prime credit loss estimates of the Bank of England with those of the IMF. These estimates are, as has been noted, not just wildly at variance with each other, but prepared without even taking note of each other. For all my respect for these two institutions, this smacks of intellectual dishonesty – and in my book, there is no greater crime.

Quite frankly, I believe the methodology of the IMF report (which leaned heavily on the paper by Greenlaw et al.) to be deeply flawed; and not just deeply flawed but deliberately skewed. So why would the IMF adopt it? They have a lot of smart people on staff; I won’t be the only person in the world to have noticed the dicey bits; why was this methodology used holus-bolus instead of simply providing the top end of a range of estimates?

My hypothesis is that it’s simply politics. The two basic factions in the investment world are those who want lots of regulation to save us from the evil Bonfire of the Vanities and those who feel that over-regulation is simply promoting inefficiency of the capital markets. These opposing forces are not comprised exclusively of idealogically pure crusaders, either! In Canada, for instance, the banks can be counted upon to promote wise regulation, not too much, not too little …. as long as whatever happens favours capital markets players who have deep, deep pockets.

There will be members of both factions on staff at the IMF, and at any regulatory group or ultimately responsibile government. Sometimes you win, sometimes you lose, in general things proceed in an ultimately half-way reasonable manner, albeit with one step back for each two steps forward. Forecasting the effects of regulation is no easier than forecasting markets … and at least when you attempt to forecast the market you have a pretty good idea of your ultimate objective!

The hard-liners in either faction are never satisfied, however – and the more cynical players, taking whatever position best serves their business will always be looking for more. Thus, every development in the capital markets is carefully examined to determine its value as a weapon in the struggle.

Canadian ABCP? It’s been used to justify a call for higher pay for regulators, to justify calls for the OSFI to expand its mandate to ensure nobody ever loses money on anything and to justify a federal regulator. The Bank of Canada has brought forth some rules to ensure that the banks never again have to worry about competition in the ABCP market from snot-nosed small corporation scum.

And so it is with Bear Stearns. I wrote about the Econbrowser post yesterday. The Econbrowser piece wanted Bernanke (i.e., the Fed) to Do Something about leverage in the brokerage industry … which is not the Fed’s purview at all, it’s in the SEC’s bailiwick. There was a note from Dave Altig of the Atlanta Fed in the Econbrowser comments, drawing attention to the Fed’s preventative measures … and still, not a word about the SEC. You can find inumerable instances of hand-wringing on the web, bewailing the fact that the Fed is (sort-of) forced to backstop a system over which it has no direct supervisory function – although, as I have pointed out, separation of lending/monetary functions and bank supervision functions are more standard throughout the world than otherwise.

The more I think about it, the more convinced I am that most of the discussion of Bear Stearns has absolutely nothing to do with a genuine desire for better regulation (you want more margin and less leverage? OK, how much more margin and how much less leverage? Let’s discuss it!) and a lot more to do with a desire to change the identities of the regulators. It’s a world-wide bureaucratic turf fight; the credit crunch, sub-prime and Bear Stearns are merely the latest weapons of convenience.

For the record, my position at the moment is that supervisory responsibility for the brokerage sector should remain with the SEC. Assiduous Readers will by now be sick and tired of reading this, but I believe the brokerages should represent a riskier and less constrained layer surrounding a banking core in the financial system. If the Central Bank has supervisory functions, there will be both a higher degree of expectation of emergency assistance in times of stress and a higher probability as well, since staff at the Central Bank – however upright and angelic their characters – will be somewhat more inclined to double-down with assistance from the discount window than to admit a possible failure of regulation and let an insolvent firm go bankrupt.

I might work this up into a formal article at some point. Remember, you read it on PrefBlog first!

As remarked by Accrued Interest, now that reports are increasing that the credit crunch is over and companies might actually be able to pay back some money, there are also growing concerns that the money we get might not be worth very much:

Bernanke and San Francisco Fed President Janet Yellen, in separate speeches yesterday, said markets remain “far from normal” after some improvement since March. Yellen, Cleveland Fed President Sandra Pianalto, Kansas City Fed President Thomas Hoenig and the Dallas Fed’s Richard Fisher said they’re concerned about rising prices.
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Yellen, 61, who doesn’t vote on rates this year, also said she anticipates consumer prices will moderate as the labor market weakens and “commodity prices level off.”

The Fed can’t be “complacent about inflation,” she told the CFA Institute Annual Conference. Recent measures of price expectations “highlight the risk that our attempts to deal with problems in the real economy could lead to higher inflation expectations and an erosion of our credibility,” she said.

Fisher, speaking in Midland, Texas, said the U.S. may be in for a “prolonged” period of slow growth, which may end with faster-than-desirable inflation.

“How deep that slowdown will be is a question mark,” said Fisher, who voted against the last three rate cuts. “I am not sure it will be very deep at all, but it may be prolonged, because we have to correct the excesses of this credit crisis.”

Naked Capitalism notes a post by Willem Buiter, who burnishes his monetarist credentials:

In a fiat money world, central banks cause inflation, or, more precisely, only central banks are resposible for inflation. Other shocks, real and nominal, can influence the general price level if the central bank does not respond swiftly and determinedly, but these non-central bank-induced changes in the general price level can always be offset by the central bank, given enough time, freedom to act and courage.

But, in the medium and long term (at horizons of two years and over, say) central banks choose the average rate of inflation. Not globalisation; not indirect taxes; not bad harvests; not OPEC and the price of oil; not the Chinese and their exchange rate management. There is no oil inflation, food inflation or cost-push inflation. There is just inflation. Inflation may be accompanied by changes in key relative prices – in the real prices of oil, of food, of oil and of labour for instance – if other relative demand and supply shocks accompany the inflationary impulses created by the central bank. Large increases in the real price of food will be bad news to food importers (including most urban households) and good news to rural food producers and exporters. But don’t confuse it with inflation.

In the petty annoyances department, Andrew Willis discusses the Sprott IPO:

Brokers are using the “anonymous” function on the TSX to do much of their selling, with 1.5 million shares sold this way. Disguising orders by not disclosing the name of the brokerage house doing the transaction fits that segment of the hedge fund and dealer crowd that prefers to be discreet. Dealers are sensitive to the issue of flipping an IPO from a money manager who also counts as a major trading client.

Does Mr. Willis know or care that it would be grossly unethical for Sprott to allow annoyance with IPO selling to influence – in any way – its trading with client money?

From Prefblog’s Out-of-time-here’s-the-links Department:

• What we know and what we would like to know about Central Bank communication
• Fed’s Direct Loans to Banks Climb to Record Level
• Bernanke Urges ‘Hunkering’ Banks to Raise Capital

Floaters finally had a bad day … they are now up a mere 8.26% on the month.

BNS issues did well:

In general, volume dropped off a little, but it was a very strong day.

There were nineteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Sorry, people! I spent most my reading time today looking at Leverage, Bear Stearns & Econbrowser, so there won’t be much commentary here.

The potential for repricing of the BCE / Teachers’ deal was discussed in the comments to May 12; now Desjardins is saying a repricing is more likely than not:

Joseph MacKay of Desjardins Securities says an agreement between Clear Channel and its private equity purchasers, which will reduce the takeout price by more than eight per cent, may put pressure on BCE to follow suit.
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However, the chance of re-pricing the deal has also increased, MacKay wrote in a report.
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“We would advise investors to assume a potential re-price in the five to 8.16 per cent range,” he wrote.

Accrued Interest is nonplussed by seemingly contradictory reports, but is sticking with his recessionary views.

Another good strong day in the market, with volume continuing to show signs of life. I note that PerpetualDiscounts are now up 0.98% month-to-date, while long corporates are up 0.91%.

There were twenty-seven other index-included $25-pv-equivalent issues trading over 10,000 shares today.

A number of regulatory links today! In another post, I discussed Derek DeCloet’s column in today’s Globe, but there were other things.

In a column in VoxEU, Xavier Vives writes a fairly general description of the problem of informational asymmetry, without giving much of a prescription for a cure. I suspect that Dr. Vives supports the Financial Stability Forum’s recommendations on simultaneous public disclosure … but this is not clear.

He makes the assertion:

The problem has been aggravated by the lack of control of who was monitoring the subprime loans. In the old-fashioned banking system institutions would monitor loans, in the world of securitised packages the market failed to provide the monitoring because rating agencies did not do their job properly and fund managers took the risk knowing that the upside was to be cashed in bonus form and the downside protected by limited liability.

… but doesn’t back it up. It should be noted that the linked paper provides no evidence that the “rating agencies did not do their job properly”; that paper by Portes seems to be getting quite a number of links on VoxEU, for reasons that I simply can’t fathom. I’ll review it at some point – I didn’t at the time, simply because it was so thoroughly generic – but in this case I’ll content myself with stating that Dr. Vives’ phrasing is not consistent with his link.

I take issue with his “second aspect”:

A second aspect of the question, made evident in the present crisis, is that, if the central bank intervenes to help institutions that are not under its supervision, it may lack the necessary information to assess whether the origin of the need is a liquidity or a solvency problem. How does the Federal Reserve know when mounting the rescue operation of a non-bank financial firm, for example, that the institution is solvent? By helping an insolvent institution taxpayers’ money is put at risk and the disciplining effect of failure eliminated. The consequence is that the moral hazard problem is exacerbated and bank managers will feel more secure in the future to take excessive risks.

Well, the “non-bank financial firm” business seems to be a tangential reference to Bear Stearns – and in that case, they know about solvency by asking the SEC. Separation of supervisory and lender of last resort functions is standard throughout much of the world – Canada and the UK, for instance – and, while not ideal, isn’t necessarily all that terrible either.

I do agree that propping up an insolvent institution would represent a misuse of the discount window – or equivalent mechanism.

Still on VoxEU, Axel Leijonhufvud wrote a rather prescient piece on inflation targetting in June, 2007:

The sanguine view is that securitisation and credit derivatives have made the world of finance a safer place than it used to be and that, besides, liquidity is ample all around. But it is not likely that the world will stay awash in liquidity forever. At some stage, central banks will have to mop it up or see inflation do it for them. Securitisation and credit derivatives have certainly dispersed risk through the economy and away from the banks where it used to be concentrated. But by the same token, the system has taken on more risk and we know less about where large concentrations of risk-bearing may be located. Risk spreads have narrowed in part permanently because of these new risk-sharing technologies, but in part transitorily because of the extraordinary level of liquidity. Narrow spreads have in turn induced some institutions to assume high leverage in search of yield.

A number of very large failures – LTCM, Enron, Amaranth – have occurred causing nary a macroeconomic ripple, and this is frequently cited as proof of the resilience that recent financial innovations have imparted to the system. It may be, however, that the more appropriate conclusion to draw is that macroeconomic developments are more likely to trigger trouble in financial markets than vice versa.

In his current article, Central banking doctrine in light of the crisis, he joins the chorus blaming Greenspan for allowing the housing bubble in the 2001-05 period:

This strategy failed in the United States. The Federal Reserve lowered the federal funds rate drastically in an effort to counter the effects of the dot.com crash. In this, the Fed was successful. But it then maintained the rate at an extremely low level because inflation, measured by various variants of the CPI, stayed low and constant. In an inflation targeting regime this is taken to be feedback confirming that the interest rate is “right”. In the present instance, however, US consumer goods prices were being stabilised by competition from imports and the exchange rate policies of the countries of origin of those imports. American monetary policy was far too easy and led to the build-up of a serious asset price bubble, mainly in real estate, and an associated general deterioration in the quality of credit.

He then argues that the elements of choice in monetary policy cast doubts on the policy of central bank independence:

Since using the bank’s powers to effect temporary changes in real variables was deemed dysfunctional, the central bank needed to be insulated from political pressures. This tenet was predicated on the twin ideas that a policy of stabilising nominal values would be politically neutral and that this could be achieved by inflation targeting. Monetary policy would then be a purely technical matter and the technicians would best be able to perform their task free from the interference of politicians.
…
When monetary policy comes to involve choices of inflating or deflating, of favouring debtors or creditors, of selectively bailing out some and not others, of allowing or preventing banks to collude, no democratic country can leave these decisions to unelected technicians. The independence doctrine becomes impossible to uphold.

It’s a tricky question! I am fully supportive of the de facto situation … the central banking chief is an unelected technician; he is appointed by the government; but the only power that the government has is to fire him – otherwise they have no say in anything. It depends a great deal on ensuring that the central banker is a paragon of integrity, not dependent upon his salary to keep food on the table.

It is accepted as pretty much a given that if the BoC governor at a given time was to be dismissed, the currency would tank and interest rates would skyrocket which – even to the most zealous investor advocate in parliament – would make it not worth firing him except for the gravest of reasons. But perhaps some thought should be given to ensuring a golden parachute that would withstand even the supremacy of parliament … I don’t know, frankly, what the current arrangements are.

And I’ll take a moment to snipe at the horrible political games-playing in the States, which has resulted in two vacancies out of seven places in the Federal Reserve Board of Governors.

Further to all the regulatory talk in this update is a post by Naked Capitalism, referencing some fashionable grandstanding by the EU:

A group of key EU finance ministers will today launch an assault on the rewards earned by bankers and top managers in a move that poses a potential threat to the City of London.

A confidential document prepared for the gathering in Brussels finds the “short-term” pay structure of modern capitalism has become deformed, causing firms to take on “excessive risk” without regard to the interests of stakeholders or society.

Geez, I’m getting old. I can remember when the short-term nature of quarterly reporting was on the verge of destroying the United States, leaving the (far-sighted and judicious long-term planning) Japanese as rightful masters of the universe.

Has anybody heard anything more about that? What happened to that story, anyway?

The other clipping republished by Naked Capitalism is with respect to a NYT interview with Kenneth C. Griffin:

Kenneth C. Griffin, who runs one of the biggest and most successful hedge fund firms, has a blunt assessment: “We, as an industry, dropped the ball.”

The breakdown happened, Mr. Griffin contends, when big investment banks gambled away money and jobs during the late great credit boom. The bosses let all those young gung-ho traders take far too many risks and now everyone is paying the price.

US brokerages are, from all the accounts I’ve heard, a lot more fun to work at than Canadian ones. In the US, if you have a good idea, you go to your supervisor … and bang! If he likes it you’ve got your funding and a deal: if it works, you, personally, will get rich. If it doesn’t, you’ll get fired. In Canada, of course, if you have a good idea, you write it up for Human Resources to look at and determine whether it’s culturally sensitive, if it harms the environment, and whether it will increase diversity and respect in the workplace. You wait a bit for their answer, then retire.

There are times – such as now! – when the free-wheeling nature of the US system got … er … a little out of hand, but we can be sure the regulatory wannabes will be only too happy to throw the baby out with the bathwater.

But Mr. Griffin isn’t just a serial complainer. He has thought about solutions.

First, “the investment banks should either choose to be regulated as banks or should arrange to conduct their affairs to not require the stop-gap support of the Federal Reserve,” he says.

But that’s not all. He also wants new government oversight of the arcane world of credit default swaps, a business with a notional value and risk of $50 trillion.
…
In particular, Mr. Griffin wants the government to require the use of exchanges and clearing houses for credit default swaps and derivatives.

The first solution is just smarmy, and reminds me of everything I’ve heard about being on (Canadian) Unemployment Insurance … they make you go to moronic seminars lead by twerps who are congenitally unemployable outside government. When you point out an obvious stupidity, they just ask ‘if you’re so smart, why don’t you have a job, while I do?’.

I feel quite certain that Bear Stearns (and the SEC, its regulator) were convinced that they had, in fact, arranged their affairs such that the stop-gap support of the Federal Reserve would not be necessary. They were wrong, they’ve lost nearly all their investment. It’s called business. Business Risk, to be precise.

I’ll be perfectly happy to consider suggested changes to the regulatory regime, capital and liquidity calculations, and to proffer plaudits and criticism as I see fit. Until these suggested changes are available for discussion, however, I suggest that Mr. Griffin and his adulatory interviewer arrange their affairs to make him sound a little less like a smarmy twerp.

Exchange Traded CDS? The Exchanges have been trying to put such a thing together for years. I understand that some of the major brokerages are trying to put together a clearinghouse … but it’s really none of the government’s damn business. The regulators can impose reasonable margin and capital rules, sure; and it’s entirely reasonable that the margin requirements for a clearing-house counterparty will be somewhat less than those for even the strongest of individual counterparties; but determining that the Official Counterparty has a monopoly on trading is going way, way, way too far.

Will I be allowed to guarantee my nephew’s car loan, or will the Official Counterparty insist on doing it and charging a fee?

Getting back to preferred shares for just a moment (sorry!) what’s up with the DFN Rights Issue? Four rights and $24.25 get you one DFN and one DFN.PR.A. Prices are:

There are two monthly dividends yet to go … $0.10 each on DFN, $0.04375 each on DFN.PR.A. Total $0.2875. So it doesn’t really look as if there’s any good arbitrage possible … but given that the NAV as of April 30 was $24.81 ($24.63 fully diluted), it seems to me that the rights are cheap. Do your own homework, though, preferably involving the modelling of the underlying portfolio!

The preferred share market put in a good honest day’s work today with good returns and even some decent (and all too infrequent, lately) volume.

There were twenty-eight other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Pundits are saying the money market shows the worst is over for credit:

The worst of the credit crisis that prompted banks to restrict lending and the Federal Reserve to rescue Bear Stearns Cos. may be over, short-term borrowing rates show.

The difference between the yield on three-month Treasury bills and the rate on dollar-denominated loans in London, an indication of credit risk known as the TED spread, narrowed 7 basis points to 0.93 basis points, the smallest since Feb. 25. The gap reached 2 percentage points on March 19.

… but the visible effects may be just getting under weigh:

As the Fed’s latest loan survey makes clear, lenders have dropped the guillotine. With the usual delay, the poison is spreading from banks to the real world.

Diane Vazza, S&P’s credit chief, says defaults are rising at almost twice the rate of past downturns. “Companies are heading into this recession with a much more toxic mix. Their margin for error is razor-thin,” she said.

Two-thirds have a “speculative” rating, compared to 50pc before the dotcom bust, and 40pc in the early 1990s. The culprit is debt. “They ramped it up in the last 18 months of the credit boom. A lot of deals were funded that should not have been funded,” she said.

Some 174 US companies are trading at “distress levels”. Spreads on their bonds have rocketed above 1,000 basis points. This does not cover the carnage among smaller firms outside the rating universe.

Meanwhile, some research is being done into the Equity premium in Victorian England:

The stock market experienced negative total returns in only four years between 1825 and 1870. Three of these years (1825, 1826 and 1847) had financial crashes after a period of promotional mania on the stock market. The negative returns in 1853 can be attributed to concerns over the impending Crimean war.
Despite the serious financial crisis of 1866 following the collapse of several banks, the market produced positive total returns in that year.

Those were the good old days, eh? The 1866 crisis was the collapse of Overend-Gurney, which I promised to discuss on March 31, but is still … er … pending.

I have updated the post on the BoE Financial Stability Report to acknowledge Willem Buiter’s objections to the BoE methodology in forecasting ultimate sub-prime losses.

MBIA, whose delays in transferring $1.1-billion from the parent to the insurance subsidiary was reported on May 7 has (as passed on by Naked Capitalism) finally made a move:

MBIA Inc., the ailing bond insurer, rose in New York Stock Exchange trading after saying it will pump $900 million into its insurance unit and reporting a first-quarter loss that was narrower than some analysts’ estimates.

Those who have been taking the Clear Channel takeover as a template for the unfolding of the BCE / Teachers’ deal will no doubt be highly interested in rumours of funding at a reduced price:

Clear Channel Communications Inc. surged as much as 18 percent on reports of settlement talks with six banks on a proposal to finance the radio broadcaster’s acquisition by two buyout firms at a reduced price.

Citigroup Inc. and five other banks may fund the buyout for $36 a share as part of a settlement of lawsuits pending in New York and Texas state courts, the Wall Street Journal reported, without saying where it got the information. That’s below the $39.20 price buyout firms agreed to pay last year and more than an intraday high of $35.30 in New York Stock Exchange trading.

Yet another day with a mysterious discontinuity in the TXPR index:

The jump was probably partly due to BAM.PR.K, which traded 300 shares at $19.40 at 9:30am, then 100 shares at $20.32 at 2:37pm. Ain’t it wonderful! Closing quotation was 19.58-20.49, 1×5. This issue comprises 1.46% of CPD (which can be assumed to be a reasonable proxy for the index, so this 4.74% jump in trading price translates to 6.9bp on the index, or about one-seventh of the total jump. Analysis of the other elements of the discontinuity is left as an exercise for the student.

All in all, though, it was a quiet day.

There were eleven other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Absolutely nothing happened today, so there’s no commentary.

I was, however, able to devote some thought to the issue of naming rights to TTC stations. It’s a great idea! Just think of the money the TTC could make from station names like:

• Old Mill-waukee
• Dundas Westjet
• The Elephant and Castle Frank
• Victoria’s Secret Park
• Viagra Makes Your Coxwell

Why, they might even be able to afford a new bucket at Osgoode Station, to replace the old one they’re currently using to catch the drips from the ceiling when it rains.

Oh, and there’s more news on the Jim Kelsoe story.

But that’s it.

There were twelve other index-included $25-pv-equivalent issues trading over 10,000 shares today

Chalk one up for the License Raj! India has halted futures trading of some commodities:

Communist allies of Prime Minister Manmohan Singh want to ban futures trading in cooking oil, sugar and other commodities, saying speculators are driving up prices. Still, the order comes a week after a government-appointed panel found no evidence a 2007 ban on wheat and rice futures curbed prices of the grains….

In hard times, there is extreme pressure on politicians to Do Something. So they do. Whether or not the actions are useful is a mere quibble. They’d be better off cutting the kerosene subsidy.

Jon Danielsson writes a piece in VoxEU attacking the concept of model-based regulation:

Most models used to assess the probability of small frequent events can also be used to forecast the probability of large infrequent events. However, such extrapolation is inappropriate. Not only are the models calibrated and tested with particular events in mind, but it is impossible to tailor model quality to large infrequent events nor to assess the quality of such forecasts.

Taken to the extreme, I have seen banks required to calculate the risk of annual losses once every thousand years, the so-called 99.9% annual losses. However, the fact that we can get such numbers does not mean the numbers mean anything. The problem is that we cannot backtest at such extreme frequencies.

A very sexy topic nowadays and, to be fair, he is familiar with the proper solution:

I think the primary lesson from the crisis is that the financial institutions that had a good handle on liquidity risk management came out best. It was management and internal processes that mattered – not model quality. Indeed, the problem created by the conduits cannot be solved by models, but the problem could have been prevented by better management and especially better regulations.

This ties in with the International Report on Risk Management Supervision. Unfortunately, he doesn’t really have any good ideas to offer for future use:

What is missing is for the supervisors and the central banks to understand the products being traded in the markets and have an idea of the magnitude, potential for systemic risk, and interactions between institutions and endogenous risk, coupled with a willingness to act when necessary. In this crisis the key problem lies with bank supervision and central banking, as well as the banks themselves.

Very nice, but just a tad lacking in specifics, wouldn’t you say?

You can’t regulate common sense. As I have said before, I think that the current credit crunch represents a triumph of the current regulatory regime: there has been pain, there have been a few failures, and there has most definitely been a pricking of the bubble … but the financial system has withstood the shocks, bloodied and in need of capital, but not in bankruptcy court with a crowd of depositors forming a lynch mob. The Basel Accords need adjustment, not elimination.

In another vein, Luigi Spaventa argues for a Brady Bond style bailout:

In CEPR Policy Insight 22, I recommend the creation of a publicly sponsored entity that could issue guaranteed bonds to banks in exchange for illiquid assets, drawing on US Treasury Secretary Nicholas Brady’s solution to the Latin American sovereign debt crisis in 1989. This new entity, preferably multilateral, would value assets based on discounted cash flows and default probabilities rather than crisis-condition market prices.

As a firm floor is set to valuation and illiquid assets otherwise running to waste are replaced by eminently liquid Brady-style bonds, funding difficulties and, at the same time, the market liquidity problems besetting the banks’ balance sheets would be removed. Shielding the banks’ assets from the vagaries of disorderly markets is a necessary condition to dispel the uncertainty that prevents a proper working of credit markets.

Nope. I don’t buy it. The amount of moral hazard engendered by such a scheme – not to mention investment risk taken by a publicly funded body – is not justified by the scale of the current problems. Dr. Spaventa’s arguments that current procedures are inadequate:

For funding liquidity, emergency liquidity support from central banks has helped lower the temperature in the worst moments, but it is not a long-term solution. Setting a collateral value of illiquid securities does not provide a market for them and hence does not set a floor to their market prices; the collateralized securities remain on the intermediaries’ books, affecting the quality of their balance sheets. Capital increases are also insufficient to break the spiral, as injections of capital may prove inadequate only a few weeks after their announcement.

For market liquidity, suggested remedies are equally inadequate. Mandated full disclosure of losses might reduce uncertainty, but unless market liquidity is instantly restored, full disclosure of the situation at time t offers no guarantee that it will be the same at time t+1. Similarly, retreating from marking financial products to market or model during this time of crisis would face a number of difficulties.

are not impressive. On the capital-raising front, we have today AIG raising $12.5-billion, while there are rumours that CitiBank is going to sell assets.

What we have is a short term crisis brought about by the (over-) financing of long term assets with short term money … this is the root of just about every general financial crisis ever known. The only solution is the passage of time.

One problem with neo-Brady-Bonds is that there will be considerable difficulty regarding negotiation of price – that is probably what killed Super-SIV / MLEC. According to the Bank of England, announced write-downs now exceed expected credit losses. It’s bad enough for the banks to take a stiff haircut when lending the securities; they’re spinning off cash; as long as they can finance them, why should they negotiate a politically palatable horrible price?

Meanwhile, Accrued Interest reviews conflicting signals from the stocks, CDS & bond markets and concludes:

A better explanation is that the market is struggling to price a world where liquidity is improving but real economics are deteriorating. It felt to me like the market, especially stocks, had become a bit too optimistic in recent days, with some even talking like we won’t have any recession at all.

Don’t confuse economic data that’s “better than expected” with “good.” Now if you ask me where the stock and credit markets will be in a year, I’d say both will be better than today. Looking one year out, we’ll probably be through this recession, housing will have bottomed, and there will be much more earnings clarity. But in the near term, I think we need a little more of a recession concession.

A quiet day in the market. Prices drifted up, with spikes in the SplitShare and InterestBearing sectors, on little volume.

There were eleven other index-included $25-pv-equivalent issues trading over 10,000 shares today.